2013 has been an interesting year for hard commodities. When you look at it closely, there has been an odd divergence. Things like gold (GLD) and silver (SLV) have performed awfully, down 21.7% and 32.3% year-to-date. However, more critical commodities to the economy like oil, as measured by the most liquid ETF available, the United States Oil Fund (USO), is up 14% year to date. What about another up and coming critical commodity in the energy space, natural gas? The most popular ETF that tracks the price of natural gas, the United States Natural Gas Fund (UNG), is actually down 9.5% year to date. In fact, natural gas is at its lowest levels in nearly 5 months, and potentially could set up for a rebound play. However, it would be really tough to make a short case after a five month decline, especially after the type of market we have had this year. Because natural gas had rebounded into 2013 after setting multi-year lows, and has been somewhat slowly on the decline in the last five months, some bearish funds that bet against natural gas have been decimated.
Direxion, a leader in providing popular alternative investment solutions, including leveraged bear funds, announced on July 24, 2013 it will execute a reverse share split of its leveraged natural gas bear fund, the Direxion Daily Natural Gas Related Bear 3X Shares ETF (GASX) which aims to provide a 300% return inverse to the moves in the ISE-Revere Natural Gas Index. The underlying index which GASX tries to provide a 3x return against was created to provide investors with a product allowing them to quickly take advantage of both event-driven news and long term trends in the Natural Gas industry. The securities selected for the index derive a substantial portion of their revenues from the exploration and production of natural gas. Given the performance of natural gas in the last year (a large rebound into 2013 and then a slow drop off over the last five months), this split is being conducted.
This split continues a line of reverse splits in bearish funds in the last few months. As the natural gas index above is down just slightly on the year after a large run up into the new year, GASX has suffered extensively. In fact, in 2013 GASX is now down 42.3% year-to-date, and is down almost 50% from its 52-week high, trading at $9.98. Because most of the holdings are performing well in the ISE-Revere natural gas index, in an effort to make investment prices more attractive for buyers, Direxion is reverse splitting the GASX as it was slowly on a path to zero. The justification is the same as most other reverse splits; that the post-split investment prices will be more attractive for buyers.
When The GASX Reverse Split Will Take Place And What Will Happen to Your Position
No other natural gas or commodity ETF products will be affected by this split, but some of Direxion's other products will be adjusted as well. The GASX reverse split will be conducted at a ratio of one new share for every four held. The reverse split will apply to shareholders of record as of the close of the markets on August 19, 2013 and will begin trading at the adjusted price August 20, 2013. The ticker symbol for the fund will not change.
The reverse split will increase the price per share of the fund with a proportionate decrease in the number of shares outstanding. In a 1 for 4 reverse split, every four pre-split shares held by a shareholder will result in the receipt of one post-split share, which will be priced four times higher than the value of the pre-split share. Let's look at an example to illustrate.
For example, if you hold 100 shares of GASX priced at $10.00 each, then after the reverse split, you will hold 25 shares valued at $40.00 each. Thus, the reverse split does not change the value of a shareholder's investment.
Again, the ticker symbol for the fund will remain the same even with the new change in price. The only change on paper for the fund is that it will be issued a new CUSIP number, which identifies the product on exchanges. There are two more considerations to think about during this split; what happens with fractional shares and what happens to owners of options contracts.
The GASX Reverse Split And Fractional Shares
For those shareholders who hold quantities of shares that are not a whole number with an exact multiple of the reverse split ratio, the reverse split will result in the creation of a fractional share. This will affect any shareholder who does not hold a number of shares that is a multiple of four. After the reverse split occurs, fractional shares will be redeemed for cash and sent to your broker of record, generally within two weeks post-split. The major issue associated with such a move is that it forces shareholders to realize either gains or losses, which could result in a taxable event for those shareholders, in addition to having a potential loss on investment if prices are below where they were purchased.
Granted, this is more of an annoyance than any kind of meaningful financial impact, however, it is relevant and needs to be mentioned. With the terrible performance year to date, a loss is pretty much guaranteed in GASX right now. One way to mitigate this fractional share issue is to purchase more shares to round out your GASX holdings to a multiple of four, or to sell an appropriate number of shares to round out the holdings.
What I Recommend For Those Holding GASX Common Stock
First, I have cautioned on the risks of holding these 3X leveraged funds for extended periods of time in the past. This is mainly because of the nature in which these funds invest and are re-weighted daily. The main issue is dealing with the effect of the daily re-weighting of holdings with these products. The fund is expected only to track daily moves, not weekly or monthly moves in the underlying index. As such, these funds really are trading vehicles in many respects; you can make a quick profit on in a couple of days or weeks. To be profitable over a several month period, we would really need a sustained bear market in the natural gas and oil space. You would need to see investors abandon equities in the sector in droves and push down futures prices to over a sustained period to get a good medium term return.
One nuance that helps make the case for owning some GASX into the reverse split, is that the new price may attract new investment dollars compared to its current sub $10 pre-split price tag. While I again point to the risk of holding these for an extended period due to the rebalancing daily of the holdings, for those holding options, there are special considerations.
What About Options Contracts On GASX?
Considering what will happen to options on this ETF is important. For those traders who may be holding options on GASX, this split will affect your contract, albeit minimally. Once Direxion conducts the reverse split, the contract undergoes an adjustment that is commonly known as "being made whole," which means the option contract is modified accordingly so that options holders are neither negatively nor positively affected by the split. While we know the reverse split will adjust the price of the underlying shares of the GASX option, the option will be adjusted so that the changes in price due to the split do not affect the value of the option.
So if there is no positive or negative effect on the option value, just how much will the option be worth post-split? You actually don't need to worry about such things, because the options clearing corporation automatically adjusts the price to maintain the option market. However, for those who want an estimate of what the GASX option will be worth, the calculation is simple.
Each GASX option contract is (usually) in control of 100 shares of GASX at some predetermined strike price. To find the new share coverage of the option after the split, all you do is simply take the split ratio and multiply by the old share coverage (normally 100 shares). To find the new strike price, take the old strike price and divide by the split ratio.
Let's look at an example:
Say you own a call option contract for 100 shares of GASX at a strike of $10.00. Since the split is 1 for 4 we divide $10.00 by 1/4, generating a new strike price of $40.00. The option will now cover 25 shares because we multiply 100 by 1/4. Thus, your new call option contract (which will expire on the same day as originally scheduled) will be good for a purchase of 25 shares of GASX for $1,000.
On your brokerage account, the contract may be adjusted to read "GASX1" or similar and still state it is worth 100 shares at the original price, but for redemption purposes, the contract would be redeemed for 25 shares at the post-split price. But should you hold these options into the reverse split?
Recommendation For Options Holders
Owners of options contracts will not be affected besides being faced with owning a new contract at a different strike price for a different number of shares. The total value of the contract will, however, remain the same. But there is an important caveat that I have detected with reverse splits. Specifically, I want to caution options holders that after the split, although you may hold a legitimate option deliverable for a certain number of shares, the volume will drop off dramatically in trading on the option shortly after the split. The effect of this is that it often leads to exceptionally wide bid/ask prices. This becomes especially true once new contracts are written that are at or near the new common share trading price. Therefore, options holders may want to trade out of these positions for this reason. Considering this is being done because we are in a bull market, anyone holding call options is likely underwater. Those holding puts may be safe to hold given the recent price action trend downward. However, I would look to get out of the option position pre-split.
GASX is down 43% in 2013, currently trading at $9.98. To bring the product to an investment price that Direxion believes is more attractive, it is conducting this reverse split. The reverse split of shares only really negatively impacts investors who own common shares that when totaled, is not a multiple of four, as they will be forced to sell fractional shares at a loss, or a potential gain, that could result in a small but annoying taxable event. Owners of options contracts will not be affected besides being faced with owning a new contract at a different strike price for a different number of shares. The total value of the contract will, however, remain the same. Options holders may want to trade out of these positions as bid/ask spreads widen and volume dries up. While the overall investment value does not change from this reverse split for those holding common shares, the only benefit is that a higher share price may attract new money, compared to the sub $10 price GASX carries now. All things considered, with natural gas at a five month low already and GASX having lost further ground during this decline, I just cannot recommend it as a buy. Rather, it can be used to trade in the short-term to profit on moves in the natural gas and oil sectors, specifically with respect to those holdings of the ISE-Revere Natural Gas Index.